Risk of Termination Clauses in Business Cooperation Agreements in Sponsor Due Diligence

The SFC’s increased scrutiny of sponsor work during the 2024-2025 enforcement cycle has placed a sharp focus on the integrity of the due diligence process, particularly the ability of a sponsor to independently verify material facts. A recurring point of failure identified in recent SFC disciplinary actions and HKEX listing decisions is the sponsor’s over-reliance on representations made in Business Cooperation Agreements (BCAs) without adequate independent verification of the underlying commercial substance. The core risk, often overlooked in the initial structuring phase, lies within the termination clauses of these BCAs. A poorly drafted or one-sided termination clause can render the entire agreement legally unenforceable or commercially meaningless, creating a material gap in the sponsor’s due diligence that the regulators will not hesitate to exploit. This article examines the specific regulatory risks posed by termination clauses in BCAs, drawing on the SFC’s Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission (the Code) and the HKEX’s Listing Rules, and provides a framework for sponsors to assess these clauses as part of their core verification procedures.

The Regulatory Framework: Sponsor’s Duty to Verify Commercial Substance

The SFC’s Code of Conduct, particularly Paragraph 17.6 and its associated Practice Notes, mandates that a sponsor must take reasonable steps to ensure that information contained in the listing document is accurate and complete in all material respects. This duty extends beyond simply collecting documents; it requires the sponsor to critically assess the commercial logic and legal enforceability of key contracts, including BCAs.

The Enforceability Standard Under Paragraph 17.6

Paragraph 17.6 of the Code requires the sponsor to conduct due diligence to a standard that would be expected of a reasonable person in the position of a sponsor. This standard explicitly includes verifying that material contracts are “valid, binding and enforceable” in accordance with their terms. For a BCA, the termination clause is the single most critical provision determining its enforceability. If a counterparty can terminate the agreement without cause on short notice, the BCA provides no substantive assurance of future revenue or business relationships. The SFC, in its 2018 Consultation Conclusions on the Regulation of Sponsors, reinforced that a sponsor must not accept a BCA at face value but must test its commercial reality through independent inquiries, including reviewing the legal effect of its termination provisions.

The HKEX’s Focus on Revenue Recognition and Business Stability

The HKEX’s Listing Rules for both the Main Board (Rule 8.05) and GEM (Rule 11.06) require a listing applicant to demonstrate a sufficient level of management continuity and financial support. A BCA that is subject to a termination clause allowing immediate cancellation by the customer—often termed a “termination for convenience” clause—directly undermines the applicant’s ability to demonstrate sustainable revenue. The HKEX’s Listing Division has, in numerous pre-IPO correspondence (e.g., in decisions regarding Rule 8.04 and 8.05), requested sponsors to provide a detailed legal analysis of termination clauses in top customer contracts. The Exchange’s concern is that a BCA with a weak termination clause is not a genuine indicator of business stability; it is a conditional arrangement that the counterparty can walk away from at any time, making the applicant’s historical financial performance a poor predictor of future results.

Identifying High-Risk Termination Clause Structures

Not all termination clauses are created equal. The risk profile varies dramatically based on the specific rights granted to each party. Sponsors must categorise these clauses into distinct risk tiers during the initial due diligence scoping.

Termination for Convenience (TFC) Clauses

This is the highest-risk structure. A TFC clause allows either party, or the customer alone, to terminate the BCA at any time, for any reason (or no reason), typically with a notice period of 30 to 90 days. From a sponsor’s perspective, a BCA with a TFC clause provides virtually no assurance of recurring revenue. The SFC and HKEX treat such agreements as non-binding expressions of intent rather than enforceable contracts. In a 2022 SFC enforcement case against a former sponsor (SFC v. [Redacted], 2022), the regulator specifically cited the sponsor’s failure to challenge the commercial logic of a BCA that contained a TFC clause, where the customer had no obligation to purchase a minimum volume. The sponsor was found to have failed in its duty to verify the “validity and binding nature” of the agreement under Paragraph 17.6(d) of the Code.

Termination for Material Breach with Narrow Definition of Breach

A lower, but still significant, risk arises when termination is only permitted for “material breach.” The risk here is the definition of “material breach” itself. If the BCA defines a material breach only as a failure to deliver a product or service for a prolonged period (e.g., 90 days), but excludes failure to meet quality standards, delivery timelines, or regulatory compliance, the clause is effectively a weak safeguard. The sponsor must assess whether the definition of “material breach” is commercially reasonable and whether it covers the key performance indicators (KPIs) that underpin the applicant’s revenue model. A narrow definition can make the BCA effectively unenforceable from the customer’s perspective, as they lack a practical remedy for poor performance.

Termination Upon Change of Control or Listing

A specific sub-category of high-risk termination clauses are those triggered by the applicant’s listing or a change of control. A BCA that states “this agreement shall terminate automatically upon the listing of [the applicant]” is a direct threat to the post-IPO business model. The HKEX’s Listing Division requires the sponsor to explain how the applicant will maintain its principal business activities after listing if a key customer contract terminates upon listing. If the BCA is a top 5 customer agreement, a change-of-control termination clause can constitute a fundamental business risk that must be disclosed in the prospectus risk factors and may require the sponsor to seek an alternative contractual arrangement or a waiver from the Exchange.

Sponsor Due Diligence Procedures for Termination Clauses

The sponsor’s response to these risks must be systematic and documented. The due diligence cannot be limited to a legal review of the BCA text; it must include operational verification of the clause’s practical application.

Step 1: Legal Enforceability Assessment

The sponsor’s legal counsel (often a Hong Kong law firm with PRC law capability) must provide a formal legal opinion on the enforceability of the termination clause under the governing law of the BCA (typically PRC law for PRC-based applicants). This opinion must address:

• Whether the termination clause is void for uncertainty (e.g., “material breach” is undefined).
• Whether the notice period is commercially reasonable.
• Whether there are any PRC statutory restrictions on termination (e.g., under the PRC Civil Code, Article 563, which provides for statutory termination rights that may override contractual terms).
• The legal consequences of a termination for convenience—specifically, whether the terminating party is liable for damages.

Step 2: Operational Verification of Termination History

The sponsor must go beyond the text. The due diligence team should:

• Request and review all correspondence between the applicant and its counterparty regarding the BCA, including any notices of termination, renewal, or amendment.
• Interview the applicant’s senior management and the counterparty’s relevant personnel (where permitted) to confirm that the termination clause has never been invoked or threatened.
• Review the applicant’s internal records for any instances where a customer has reduced purchase volumes or delayed payments, which could indicate an informal invocation of termination rights.
• Cross-reference the BCA’s termination provisions with the applicant’s revenue recognition policy under HKFRS 15. If the BCA is terminable at will, the revenue recognised from that contract may not qualify as “highly probable” under the standard, potentially requiring a reclassification of the revenue stream.

Step 3: Stress-Testing the Business Model

The sponsor must model the financial impact of a hypothetical termination of the BCA. This analysis should:

• Quantify the percentage of total revenue and gross profit attributable to the BCA.
• Calculate the impact on the applicant’s liquidity and solvency ratios if the BCA were terminated.
• Assess the applicant’s ability to replace the lost business within a commercially reasonable timeframe (e.g., 6-12 months).
• If the BCA accounts for more than 20% of total revenue, the sponsor should consider this a material risk requiring enhanced disclosure in the prospectus under HKEX Listing Rules Rule 11.07 (for GEM) or the equivalent Main Board requirements. The sponsor must also consider whether the applicant can meet the profit requirement under Rule 8.05 without this contract.

Disclosure and Risk Factor Considerations

Where a high-risk termination clause is identified, the sponsor’s obligations extend to the prospectus itself. The disclosure must be precise and not generic.

Material Contract Disclosure

Under the Listing Rules (Appendix 1A, Part A, Paragraph 27 for Main Board; Appendix 1A, Part A, Paragraph 27 for GEM), the prospectus must include particulars of every material contract. For a BCA with a high-risk termination clause, the sponsor must ensure the prospectus discloses:

• The exact nature of the termination clause (e.g., “The Customer may terminate the Agreement for any reason upon 30 days’ written notice”).
• The financial significance of the contract to the applicant (percentage of revenue, gross profit, and total assets).
• The potential consequences of termination on the applicant’s business, financial condition, and results of operations.

Specific Risk Factor Language

The risk factor section must not use boilerplate language. It should state, for example: “The Company’s revenue is materially dependent on a BCA with Customer A, which may be terminated by Customer A for convenience upon 30 days’ notice. Any such termination would have a material adverse effect on the Company’s business, financial condition, and results of operations, and may render the Company unable to meet the continued listing criteria of the Stock Exchange.” The sponsor should also consider whether a separate “going concern” risk factor is warranted if the termination clause exposes the applicant to a material uncertainty over its ability to continue as a going concern.

Actionable Takeaways for Sponsors

1. Classify termination clauses into three risk tiers (Termination for Convenience, Narrow Material Breach, Change of Control) during the initial due diligence scoping, and allocate verification resources proportionally to the highest-risk agreements.
2. Obtain a formal legal opinion from qualified PRC or governing-law counsel on the enforceability of the termination clause under applicable law, specifically addressing any statutory override rights.
3. Verify the operational history of the termination clause by reviewing correspondence and interviewing counterparty personnel, not just the contractual text.
4. Quantify the financial impact of a hypothetical termination and model the applicant’s ability to replace the lost business within 12 months, treating any BCA representing over 20% of revenue as a material risk.
5. Draft precise risk factor language that names the specific termination clause, the counterparty, and the quantified financial exposure, avoiding generic statements that fail to inform investors of the specific contractual vulnerability.